Rethinking Total Equity Market Exposure

There can be a potential performance advantage to tilting a core equity portfolio to smaller cap and value stocks, as was demonstrated by the work of Eugene F. Fama and Kenneth R. French in the early 1990s.

A market-weighted index is a common means of capturing total equity market exposure. Many investors believe that owning companies in proportion to their size in the market – as determined by the number of shares available to the public and the market price of the stock – creates the “optimal stock portfolio.” 1

But academic research and empirical evidence suggest that market weighting builds in a bias toward speculative growth and larger companies. Growth companies typically trade at higher multiples to their earnings or book value.2 The price for the firm’s stock is higher and so, in turn, is its market capitalization.

The investor who seeks total equity market exposure via a market-weighted index may pay more for each dollar of earnings or equity for growth companies. At the same time, he or she may not be fully compensated for the risks being taken by under-exposure to small cap and value stocks.

TILTING TOWARD SMALLER CAPS AND VALUE

There can be a potential performance advantage to tilting a core equity portfolio to smaller cap and value stocks, as was demonstrated by the work of Eugene F. Fama and Kenneth R. French in the early 1990s. Prior to Fama and French’s work, the general belief was that the expected future performance of a stock was tied directly to the volatility of the stock’s price versus that of the market. In other words, a stock whose price was more volatile (i.e., riskier) than the market – or had a beta greater than 1 – should earn more than the market return, to compensate the investor for taking on the additional risk.

But Fama and French found that beta did not fully explain the returns of a stock over time. Their research showed that two other factors played key roles in determining the expected future return of a company’s stock: the size of the company and its valuation. They found that the smaller a company’s market capitalization and the higher the ratio of the firm’s book value to its market value, the greater was its expected return. They also found that the return premiums provided by size and value factors were persistent over long periods of time.

Fama and French found that 90–95% of manager outperformance above beta was directly related to the size and value risk premiums.

Why are size and value premiums available? There are two competing theories.

Those who believe that the market is efficient and that securities are always priced correctly think that any outperformance is likely due to the increased risk associated with smaller-capitalized companies and value firms.

Size risk premium: Firms that are less established (smaller) need to compensate investors by offering them greater returns for taking on excess risk (independent of price volatility).

Those who believe that markets are inefficient think any outperformance is likely a function of the mispricing of these companies.

Size premium: Smaller companies are perceived as not providing investors with sufficient information (quality and quantity) to be accurately valued.

Value premium: What these companies are worth can often be underestimated because they are deemed to offer limited growth prospects.

The Reality Behind Manager Skill

By applying regression analysis to historical returns, Fama and French found that 90–95% of manager performance was directly related to exposure to three factors: sensitivity to market volatility (market beta), exposure to the size risk premium and exposure to the value risk premium. The remainder was attributed to the manager’s skill in selecting stocks, known as alpha. Previously, under the Capital Asset Pricing Model (CAPM) one-factor model, active manager performance was viewed as coming from just two sources: the market beta of the portfolio (responsible for approximately 70% of expected returns) and alpha. Fama and French determined that many managers had “outperformed” their CAPM beta by adding exposure in their portfolios to small caps and value stocks.

MORNINGSTAR U.S. MARKET FACTOR TILT INDEX

Size

In order to effectively capture a more substantial size premium from the market, an index needs to delve deeper into the investable universe than traditional broad market indexes. The Morningstar U.S. Market Factor Tilt Index holds 99.5% of the investable U.S. equity universe. By going deeper than other market indexes, the Morningstar Index seeks to capture more of the size premium while still avoiding the very bottom of the market that may have illiquidity issues.

Value

The Morningstar Index also uses its proprietary value orientation score to classify securities that are undervalued and overvalued. This value orientation score is part of Morningstar’s style box framework for individual stocks, mutual funds and ETFs. The Morningstar approach incorporates both forward-looking and historical factors into its classification methodology. The use of multiple value factors mitigates the risk of a stock being misclassified due to a company’s management decisions about financing options, cash flow usage, dividend policy or financial reporting.

1 This is a key component of Harry Markowitz’s research on Modern Portfolio Theory.2 Book value is the sum of capital surplus, common stock and retained earnings.3 Alpha is a fund’s excess return relative to its benchmark.